You bought a crypto WHAT? A quick guide to NFTs

People have been making money this year selling NFTs. Big money.

The hype really began when Grimes sold US$6 million worth of digital art as NFTs. American DJ Justin Blau, aka 3LAU, made US$11.8 million via an online auction over the course of a few days (apparently, the first time he has made meaningful money from his music). Your authors were hanging out in the room in the social media app Clubhouse when the auction reached its climax. Clubhouse has fueled the fire. NFL star Gronk was in the room chatting with the moderators about his recent drop of digital Gronk sports collectibles. Various Silicon Valley types were also chatting in the room about their growing NFT collections, paid for with millions of dollars’ worth of cryptocurrency.

To some, an NFT has become the new Picasso. Proudly displayed – somehow, perhaps on a bank of screens – in their home. Alternatively, squirreled away on the blockchain, unknown to anyone except the owner (think: a collector who is satisfied keeping their Picasso in a vault). Digital artist Beeple sold an NFT of his digital artwork collection for a whopping US$69 million, Kings of Leon became the first band in the world to release an album as an NFT, and Twitter founder Jack Dorsey sold his first ever tweet as an NFT for over US$2.9 million. The hype has even reached Australia – Aussie musician Flume sold an NFT linked to 90 seconds of his music for A$66,000 and a Melbourne art gallery recently opened an exhibition where paintings are being sold along with an NFT that represents the artwork.

So, what are NFTs?

NFT stands for “non-fungible token”. Tokenisation refers to the creation of a digital asset. A token can be used to represent anything, be it a digital asset or a physical object. So far we’ve seen digital art, music, collectibles, video footage, real-world assets (e.g. real estate and designer sneakers) being tokenised and sold. Someone took a screenshot of a Clubhouse room they were in while people were discussing NFTs, turned it into an NFT (tokenised it), and put it up for sale. Talk about the world eating itself.

By being “non-fungible”, each token is unique. It can’t be substituted – unlike money, which is fungible. A bitcoin is also fungible. It is this feature of originality and scarcity that makes it particularly attractive once it is integrated with digital media.

Notably, while the token is unique, the underlying content tends not to be. You can buy an NFT of video footage of a Le Bron James dunk. Or a famous song. The video footage or audio is validly and freely available elsewhere. But if you buy the NFT, you own that NFT. It’s like owning an original Picasso instead of a print. But only sort of, because there is a clear practical difference between an original Picasso and a print. Does the same distinction exist between a video you watch on your iPhone as an NFT, or a video you watch on your iPhone on YouTube? It depends who’s answering.

In terms of the technology, broadly speaking, NFTs are part of the Ethereum blockchain (although tokenisation can occur on any blockchain). While Ethereum is a blockchain, it has an associated cryptocurrency called Ether. NFTs are traded using cryptocurrency (predominantly Ether, but it could be anything) and a record of each transaction is recorded on the blockchain, making it a permanent public record and serving as a certification of authenticity that, supposedly, cannot be tampered with.

NFTs have particularly excited artists, who see opportunities to connect with new audiences and monetise their work without expensive intermediaries such as producers, record labels and streaming platforms. Electronic music producer 3LAU, referred to above, looked to NFTs as the pandemic brought his music-touring business to a halt, cutting off his main source of income. He has now, maybe, forged a path for himself and other artists interested in a revenue stream they control themselves as well as opening up a way for artists to connect directly with their fan communities (e.g. of the 33 NFTs sold by 3LAU, the most premium NFT offered a custom song with the winner’s creative direction as well as unreleased music).

Legal implications

The market for NFTs is currently a bit like the Wild West. As far as we can tell, the people who are transacting NFTs are doing so without the benefit of much work having been done around the contractual terms and without a clear view on how NFTs fit into existing regulatory frameworks. So, when you pay $69 million for a digital artwork collection, what are you actually buying? Is it a regulated transaction? What about tax?

Here is our attempt to start to identify some of the legal issues. We don’t pretend to have all the answers. It’s clear there is a great deal of legal work to be done to clarify how to properly transact NFTs.

What you’re actually buying

When you buy an NFT, what you’re purchasing is not the underlying asset the NFT represents but rather just the token (i.e. a cryptographically signed “receipt” that proves you own that particular digital asset in the blockchain). Ideally your token would contain the digital asset (e.g. the music file or artwork) as well as details of any other transactions associated with that digital asset and the artist (presumably the owner) but in reality it probably contains much less. What it will contain is metadata, which provides the specific descriptive information for each token ID. In most cases, this metadata won’t be stored on the token and what you will get is a link “off-chain” to a website where the digital asset will actually be stored. “On-chain” storage is possible, but storage limitations of Ethereum makes it difficult and expensive to store everything on-chain. So what you’re really buying is not that digital painting or music file, but merely a pass and map to where it is.

From a copyright perspective that means the pre-existing copyright owner such as the artist who created the work will continue to be the copyright owner and have certain exclusive rights to control the use of the work. For the copyright in the underlying asset to be assigned it would require a binding agreement between the parties to that effect. In the absence of such an assignment, all the underlying intellectual property rights will continue to be owned by the artist or copyright owner.

So, unless you contractually manage to acquire the IP rights to the underlying asset, maybe what you are buying is an implied non-exclusive licence to display the asset in your token wallet for personal use only. The difficulty is that parties to these transactions are not negotiating contract terms. At most, they are transacting under umbrella terms and conditions imposed by the digital marketplace. In the absence of clear terms, it is difficult to see how the buyer could assert many rights in their newly purchased NFT. Quite possibly, they don’t even get the right to display the asset on other products, websites or platforms (so you should probably check the terms before uploading a screenshot of your NFT collection on Instagram).

(As an aside, there appear to be high levels of trust in the NFT collector space, with some collectors appearing to be quite ideologically motivated to subvert mainstream capitalist systems and markets.)

If ownership of an NFT does not confer IP rights in the underlying asset, there is presumably nothing stopping people from “minting” (or creating) an NFT of another person’s work (or in William Shatner’s case, his tweets) and selling it. While in a perfect world people would ask permission from the copyright owner, what happens if they don’t (or can’t)?

Remember when YouTube first started? Everyone uploaded whatever they wanted without any regard to copyright until copyright owners realised they needed to take steps to protect their copyright. It looks like the same thing might happen in the NFT space. Perhaps it is only a matter of time until a Hollywood studio sends in its army of lawyers to send cease and desist letters (or DMs?) to all the sellers who have tokenised that studio’s IP without their permission (think cute Disney snippets etc).

The NFT marketplace platforms who facilitate the sales are an interesting piece of the puzzle. Digital platforms such as Nifty Gateway and OpenSea have made buying and selling NFTs accessible to almost everyone. Trading occurs through smart contracts (which is just code programmed to execute a transaction) and although these can be configured to include certain terms and conditions, most sellers are not doing so (where to start?). Many of them are aware they should be, but it’s in the too hard basket. An example of the too hard basket is some platforms (e.g. OpenSea) give original creators the ability to earn revenue from secondary sales every time the NFT changes hands (long-coveted by artists). But how does that all work contractually and practically?

What about the NFT itself – does it give rise to a chose in action? Could the token be protected by copyright? What would happen if the underlying asset is altered or disappears? (Imagine paying $2.9 million for the world’s first tweet and it gets deleted. Or maybe your NFT becomes even more valuable in that case?) What if the “off-chain” link to your underlying asset stops working because the website stops functioning or someone ceases to host it? What if the platform that sold the NFT goes under and stops hosting the digital assets? Can you mint multiple NFTs from the same asset and sell them on different platforms?

Financial regulation

ASIC’s information sheet on initial coin offerings and crypto-assets will likely be applicable to NFT participants in Australia. It appears that whether an NFT will be deemed to be a financial product by ASIC will depend on the rights attached to it. How can we answer that when we don’t even know what rights are attached (as discussed above)? Although a number of American lawyers have opined it is unlikely that NFTs (particularly those that represent artwork or collectibles) will be deemed to be financial products, the definition of a ‘financial product’ in Australia is broader than other jurisdictions so there is a possibility that NFT platforms may be operating a financial market in Australia.

Tax

How will the ATO deal with NFTs? We’re not the first to ask, but the ATO seems to think NFTs are a type of cryptocurrency, which is incorrect. When you buy an NFT, you dispose of Ether. Capital gains tax issues? Income tax for the seller?

Are NFTs here to stay, or is this a flash in the pan, perhaps driven by bored people in lockdown with nothing else to spend their money on? Who knows, but for now the vibe and, dare we say FOMO, on Clubhouse is real.

By the way, if you’d like to mint this paper into an NFT, please contact us first and we can negotiate terms!


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